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Chapter 8

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  1. Chapter 8 Profit Maximization and Competitive Supply

  2. Topics to be Discussed • Perfectly Competitive Markets • Profit Maximization • Marginal Revenue, Marginal Cost, and Profit Maximization • Choosing Output in the Short-Run Chapter 8

  3. Topics to be Discussed • The Competitive Firm’s Short-Run Supply Curve • Short-Run Market Supply • Choosing Output in the Long-Run • The Industry’s Long-Run Supply Curve Chapter 8

  4. Perfectly Competitive Markets • Characteristics of Perfectly Competitive Markets 1) Price taking 2) Product homogeneity 3) Free entry and exit Chapter 8

  5. Perfectly Competitive Markets • Price Taking • The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. • The individual consumer buys too small a share of industry output to have any impact on market price. Chapter 8

  6. Perfectly Competitive Markets • Product Homogeneity • The products of all firms are perfect substitutes. • Examples • Agricultural products, oil, copper, iron, lumber Chapter 8

  7. Perfectly Competitive Markets • Free Entry and Exit • Buyers can easily switch from one supplier to another. • Suppliers can easily enter or exit a market. Chapter 8

  8. Perfectly Competitive Markets • Discussion Questions • What are some barriers to entry and exit? • Are all markets competitive? • When is a market highly competitive? Chapter 8

  9. Profit Maximization • Do firms maximize profits? • Possibility of other objectives • Revenue maximization • Dividend maximization • Short-run profit maximization Chapter 8

  10. Profit Maximization • Do firms maximize profits? • Implications of non-profit objective • Over the long-run investors would not support the company • Without profits, survival unlikely Chapter 8

  11. Profit Maximization • Do firms maximize profits? • Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior. Chapter 8

  12. Marginal Revenue, Marginal Cost,and Profit Maximization • Determining the profit maximizing level of output • Profit ( ) = Total Revenue - Total Cost • Total Revenue (R) = Pq • Total Cost (C) = Cq • Therefore: Chapter 8

  13. Total Revenue R(q) Slope of R(q) = MR Profit Maximization in the Short Run Cost, Revenue, Profit ($s per year) 0 Output (units per year) Chapter 8

  14. C(q) Total Cost Slope of C(q) = MC Why is cost positive when q is zero? Profit Maximization in the Short Run Cost, Revenue, Profit $ (per year) 0 Output (units per year) Chapter 8

  15. Marginal Revenue, Marginal Cost,and Profit Maximization • Marginal revenue is the additional revenue from producing one more unit of output. • Marginal cost is the additional cost from producing one more unit of output. Chapter 8

  16. C(q) R(q) A B q0 q* Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels: 0- q0: • C(q)> R(q) • Negative profit • FC + VC > R(q) • MR > MC • Indicates higher profit at higher output Cost, Revenue, Profit ($s per year) 0 Output (units per year) Chapter 8

  17. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Question: Why is profit negative when output is zero? Chapter 8

  18. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels: q0 - q* • R(q)> C(q) • MR > MC • Indicates higher profit at higher output • Profit is increasing Chapter 8

  19. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output level: q* • R(q)= C(q) • MR = MC • Profit is maximized Chapter 8

  20. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Question • Why is profit reduced when producing more or less than q*? Chapter 8

  21. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels beyond q*: • R(q)> C(q) • MC > MR • Profit is decreasing Chapter 8

  22. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Therefore, it can be said: • Profits are maximized when MC = MR. Chapter 8

  23. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 8

  24. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 8

  25. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • Price taker • Market output (Q) and firm output (q) • Market demand (D) and firm demand (d) • R(q) is a straight line Chapter 8

  26. $4 d $4 D Demand and Marginal Revenue Facedby a Competitive Firm Price $ per bushel Price $ per bushel Firm Industry Output (millions of bushels) Output (bushels) 100 200 100

  27. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • The competitive firm’s demand • Individual producer sells all units for $4 regardless of the producer’s level of output. • If the producer tries to raise price, sales are zero. Chapter 8

  28. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • The competitive firm’s demand • If the producers tries to lower price he cannot increase sales • P = D = MR = AR Chapter 8

  29. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • Profit Maximization • MC(q) = MR = P Chapter 8

  30. Choosing Output in the Short Run • We will combine production and cost analysis with demand to determine output and profitability. Chapter 8

  31. MC Lost profit for qq < q* Lost profit for q2 > q* A D AR=MR=P ATC C B AVC At q*: MR = MC and P > ATC q1 : MR > MC and q2: MC > MR and q0: MC = MR but MC falling q0 q1 q* q2 A Competitive FirmMaking a Positive Profit Price ($ per unit) 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output Chapter 8

  32. MC ATC B C D P = MR A At q*: MR = MC and P < ATC Losses = P- AC) x q* or ABCD AVC F E q* A Competitive FirmIncurring Losses Price ($ per unit) Would this producer continue to produce with a loss? Output Chapter 8

  33. Choosing Output in the Short Run • Summary of Production Decisions • Profit is maximized when MC = MR • If P > ATC the firm is making profits. • If AVC < P < ATC the firm should produce at a loss. • If P < AVC < ATC the firm should shut-down. Chapter 8

  34. Observations • Price between $1140 & $1300: q = 600 • Price > $1300: q = 900 • Price < $1140: q = 0 P2 P1 Question Should the firm stay in business when P < $1140? The Short-Run Output ofan Aluminum Smelting Plant Cost (dollars per item) 1400 1300 1200 1140 1100 Output (tons per day) 0 300 600 900 Chapter 8

  35. Some Cost Considerations for Managers • Three guidelines for estimating marginal cost: 1) Average variable cost should not be used as a substitute for marginal cost. Chapter 8

  36. Some Cost Considerations for Managers • Three guidelines for estimating marginal cost: 2) A single item on a firm’s accounting ledger may have two components, only one of which involves marginal cost. Chapter 8

  37. Some Cost Considerations for Managers • Three guidelines for estimating marginal cost: 3) All opportunity cost should be included in determining marginal cost. Chapter 8

  38. The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production. MC ATC P2 AVC P1 What happens if P < AVC? P = AVC q1 q2 A Competitive Firm’sShort-Run Supply Curve Price ($ per unit) Output Chapter 8

  39. A Competitive Firm’sShort-Run Supply Curve • Observations: • P = MR • MR = MC • P = MC • Supply is the amount of output for every possible price. Therefore: • If P = P1, then q = q1 • If P = P2, then q = q2 Chapter 8

  40. A Competitive Firm’sShort-Run Supply Curve S = MC above AVC Price ($ per unit) MC ATC P2 AVC P1 P = AVC Shut-down Output q1 q2 Chapter 8

  41. A Competitive Firm’sShort-Run Supply Curve • Observations: • Supply is upward sloping due to diminishing returns. • Higher price compensates the firm for higher cost of additional output and increases total profit because it applies to all units. Chapter 8

  42. A Competitive Firm’sShort-Run Supply Curve • Firm’s Response to an Input Price Change • When the price of a firm’s product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. Chapter 8

  43. Input cost increases and MC shifts to MC2 and q falls to q2. MC2 Savings to the firm from reducing output MC1 $5 q2 q1 The Response of a Firm toa Change in Input Price Price ($ per unit) Output Chapter 8

  44. The MC of producing a mix of petroleum products from crude oil increases sharply at several levels of output as the refinery shifts from one processing unit to another. SMC How much would be produced if P = $23? P = $24-$25? The Short-Run Productionof Petroleum Products Cost ($ per barrel) 27 26 25 24 Output (barrels/day) 23 8,000 9,000 10,000 11,000 Chapter 8

  45. The Short-Run Productionof Petroleum Products • Stepped SMC indicates a different production (cost) process at various capacity levels. • Observation: • With a stepped MC function, small changes in price may not trigger a change in output. Chapter 8

  46. The Short-Run Productionof Petroleum Products • The short-runmarket supply curve shows the amount of output that the industry will produce in the short-run for every possible price. • Consider, for simplicity, a competitive market with three firms: Chapter 8

  47. S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. MC1 MC2 MC3 P3 P2 P1 Industry Supply in the Short Run $ per unit Question: If increasing output raises input costs, what impact would it have on market supply? Quantity 0 2 4 5 7 8 10 15 21 Chapter 8

  48. The Short-Run Market Supply Curve • Elasticity of Market Supply Chapter 8

  49. The Short-Run Market Supply Curve • Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output. • Perfectly elastic short-run supply arises when marginal costs are constant. Chapter 8

  50. The Short-Run Market Supply Curve • Questions 1) Give an example of a perfectly inelastic supply. 2) If MC rises rapidly, would the supply be more or less elastic? Chapter 8